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Strategic Management and Corporate Finance · Project Evaluation

Non-Discounted Techniques: Payback Period and ARR

Updated 11 October 2026 · Fact-checked

Payback period is the time a project takes to recover its initial outlay from cash inflows. Accounting rate of return (ARR) is average annual accounting profit divided by investment. Neither discounts cash flows. Discounted payback does, so it is stricter. Pick the project that recovers cost sooner or earns a higher ARR.

Understand Non-Discounted Techniques: Payback and ARR

Capital budgeting asks one question: is a project worth its cost? Non-discounted techniques answer it without applying the time value of money. They are simple, which is why firms still use them as quick screens.

The payback period measures how long cash inflows take to repay the initial investment. A shorter payback means faster recovery and lower risk. Management often fixes a maximum acceptable period. If the project pays back within it, accept; otherwise reject. Between mutually exclusive projects, choose the shorter payback.

The discounted payback period fixes the biggest flaw of simple payback. It first discounts each year's cash inflow at the cost of capital, then finds when the cumulative present values equal the outlay. It is always longer than simple payback for a positive discount rate.

The accounting rate of return (ARR) uses accounting profit, not cash flow. You take average annual profit after depreciation and tax, and divide by either the initial or the average investment. Accept if ARR is above a target rate. Choose the higher ARR among alternatives.

All three are easy to compute, but simple payback ignores cash flows after the payback date and the timing of flows within it. ARR ignores cash flow timing altogether and depends on accounting policies such as the depreciation method.

Key rules to remember

Payback period (even inflows)
Payback = Initial investment ÷ Annual cash inflow
Use only when every year's cash inflow is equal.
Payback period (uneven inflows)
Payback = Years fully recovered + (Unrecovered cost at start of the final year ÷ Cash inflow of that year)
Build the cumulative cash inflow column first. Assumes inflows arise evenly within the year.
Discounted cash inflow
PV = Cash inflow × 1 ÷ (1 + r)^n
r is the cost of capital, n is the year. Use PV factors if given.
Discounted payback
Same as uneven payback, but using cumulative present values
Compare against the initial outlay, not against undiscounted flows.
ARR on initial investment
ARR = Average annual profit after depreciation and tax ÷ Initial investment × 100
Use the basis the question states.
ARR on average investment
Average investment = (Initial investment + Salvage value) ÷ 2; ARR = Average annual profit ÷ Average investment × 100
If extra working capital is needed, add it to both the initial and the average investment, as the question's treatment directs.
Average annual profit
Average profit = Total profit after depreciation and tax over life ÷ Number of years
Profit is accounting profit, not cash flow.

How to solve Non-Discounted Techniques: Payback and ARR questions

Follow the same order for any payback or ARR question. It keeps your answer easy for the examiner to follow.

  1. 1Read what is asked: payback, discounted payback, ARR, or a comparison and recommendation.
  2. 2Note the outlay, life, salvage value, tax rate, depreciation method and cost of capital.
  3. 3For payback, convert profits to cash inflows if needed: cash inflow = profit after tax + depreciation.
  4. 4Build a table with year, cash inflow and cumulative inflow. For discounted payback, add discount factor, present value and cumulative present value.
  5. 5Locate the year where cumulative inflow crosses the outlay, then interpolate for the fraction of that year.
  6. 6For ARR, compute average profit after depreciation and tax, then divide by the investment base stated.
  7. 7Compare with the cut-off or alternative project and state the decision.
  8. 8Add one line on limitations, such as time value ignored or flows after payback ignored.

Quickest way: Cumulative column shortcut

When to use it: Use when inflows are uneven and you must find payback fast.

  1. Write the outlay at the top of a cumulative column.
  2. Subtract each year's inflow until the balance would turn negative.
  3. Divide the balance left at that year's start by that year's inflow.
  4. Add this fraction to the completed years.
  5. For discounted payback, multiply each inflow by its factor before subtracting.

Common mistakes in Non-Discounted Techniques: Payback and ARR

  • Using profit instead of cash inflow for payback.

    The question gives profit figures and students use them directly.

    Fix: Add back depreciation to profit after tax to get cash inflow.

  • Forgetting to deduct depreciation when computing ARR.

    Students treat cash flow and profit as the same.

    Fix: ARR uses accounting profit after depreciation and tax.

  • Dividing by the wrong investment base in ARR.

    Students ignore whether the question says initial or average investment.

    Fix: Underline the base in the question. If silent, state your choice and show it.

  • Applying the even-inflow formula to uneven flows.

    It is the quickest formula to recall.

    Fix: Use it only if all annual inflows are equal. Otherwise use the cumulative table.

  • Comparing discounted payback with undiscounted cumulative flows.

    Students discount some years but not others.

    Fix: Discount every year and accumulate only present values.

  • Ignoring salvage value in average investment.

    Students use half the outlay by habit.

    Fix: Use (Initial investment + Salvage value) ÷ 2 when salvage is given.

Worked examples

Example 1

A project costs ₹10,00,000. Cash inflows are ₹3,00,000, ₹4,00,000, ₹4,00,000 and ₹3,00,000 in years 1 to 4. Cost of capital is 10%. Discount factors are 0.909, 0.826, 0.751 and 0.683. Find the payback period and discounted payback period.

Show the solution
  1. Cumulative inflows: year 1 ₹3,00,000; year 2 ₹7,00,000; year 3 ₹11,00,000.
  2. Payback falls in year 3. Unrecovered at start of year 3 = ₹10,00,000 − ₹7,00,000 = ₹3,00,000.
  3. Payback = 2 + 3,00,000 ÷ 4,00,000 = 2.75 years.
  4. Present values: year 1 = 3,00,000 × 0.909 = ₹2,72,700; year 2 = 4,00,000 × 0.826 = ₹3,30,400; year 3 = 4,00,000 × 0.751 = ₹3,00,400; year 4 = 3,00,000 × 0.683 = ₹2,04,900.
  5. Cumulative PV: ₹2,72,700; ₹6,03,100; ₹9,03,500; ₹11,08,400.
  6. Recovery falls in year 4. Unrecovered at start of year 4 = ₹10,00,000 − ₹9,03,500 = ₹96,500.
  7. Discounted payback = 3 + 96,500 ÷ 2,04,900 = 3 + 0.471 = 3.47 years.

Answer: Payback period is 2.75 years. Discounted payback period is about 3.47 years.

Example 2

Asha Textiles buys a machine for ₹8,00,000 with a life of 4 years and nil salvage value. Profits after depreciation and tax are ₹1,20,000, ₹1,60,000, ₹2,00,000 and ₹1,60,000 in years 1 to 4. Depreciation is straight line. Find the payback period and ARR on average investment.

Show the solution
  1. Annual depreciation = ₹8,00,000 ÷ 4 = ₹2,00,000.
  2. Cash inflows = profit + depreciation: ₹3,20,000; ₹3,60,000; ₹4,00,000; ₹3,60,000.
  3. Cumulative: ₹3,20,000; ₹6,80,000; ₹10,80,000.
  4. Unrecovered at start of year 3 = ₹8,00,000 − ₹6,80,000 = ₹1,20,000.
  5. Payback = 2 + 1,20,000 ÷ 4,00,000 = 2.3 years.
  6. Total profit = 1,20,000 + 1,60,000 + 2,00,000 + 1,60,000 = ₹6,40,000. Average profit = ₹6,40,000 ÷ 4 = ₹1,60,000.
  7. Average investment = (8,00,000 + 0) ÷ 2 = ₹4,00,000.
  8. ARR = 1,60,000 ÷ 4,00,000 × 100 = 40%.

Answer: Payback period is 2.3 years. ARR on average investment is 40%.

Exam tips

  • Show the cumulative table even when the answer looks obvious. Marks are given for method.
  • State the decision rule and your recommendation in one closing sentence.
  • Write limitations briefly: payback ignores time value and later flows; ARR ignores timing and relies on accounting profit.
  • If the question mentions discounted payback, expect a comparison with simple payback and with NPV.
  • Write assumptions, such as inflows arising evenly within a year, before you calculate.

Practice questions from Project Evaluation

Non-Discounted Techniques: Payback and ARR in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Non-Discounted Techniques: Payback and ARR: frequently asked questions

What is the difference between payback and discounted payback?

Simple payback uses raw cash inflows. Discounted payback converts each inflow to present value at the cost of capital first. So discounted payback is longer and accounts for time value of money.

Is ARR based on cash flow?

No. ARR uses accounting profit after depreciation and tax. That is why it can differ sharply from cash-based measures and from NPV.

Which investment base should I use for ARR?

Use the base the question states, either initial or average investment. If it does not say, state which you use and show the working.

Why do firms still use payback if it has flaws?

It is simple, quick and shows how fast money is recovered. This matters when liquidity is tight or the future is uncertain. It works best as a screening tool alongside NPV or IRR.